ROBERT A. HAUGEN
Professor of Finance, UCI Graduate School of Management
Robert A. Haugen’s market theories run counter to conventional stock-market wisdom. In his soon-to-be-released book, “The New Finance,” he argues that the highest-risk stocks can be expected to produce the lowest returns to investors over time and the lowest-risk stocks, the highest returns. In an interview last week with Times Correspondent Debora Vrana, Haugen explained his theory that the stock market is inefficient and wrongly values stocks. He also gave his view of the best long-term bets among Orange County companies.
Question: Your view of the stock market is startling. Why do you think “value” stocks perform better than high-risk growth stocks?
Answer: Well, a growth stock is a stock that is expected to grow faster than average for some period into the future. A value stock is expected to grow slower than average, and it’s as simple as that. The question is, for how long into the future can you project that a stock will grow faster or slower than average? And the market’s assessment . . . has changed dramatically over the century.
Q: How so?
A: In the early 1920s, growth prospects were not considered at all in valuing a company. Valuation was based on the current earning power, not the future potential for growth or decline in that earning power. Back then, they believed that potential for future growth or decline was unpredictable, so they didn’t consider it. In 1925, a guy named Edgar Lawrence Smith wrote a book called “Common Stocks as Long-Term Investments,” and in it he invented growth stocks. He said that stocks had done well compared to bonds in term of returns and said the source of that superior performance was that stocks could grow, bonds could not. He said we were wrong in the way we were valuing stocks and that the potential for growth should be taken into account, and stocks that have greater potential for growth should sell at higher prices.
But no evidence was brought to the table that future growth is predictable. Obviously if it isn’t, we shouldn’t consider it. The old-timers were right. But his book became a best seller and changed the face of investing. By the end of 1929 we had growth and value stocks, but in October that year the market collapsed, and with it collapsed this idea. Through the ‘30s, ‘40s and ‘50s, the ideas of other people were supreme, basically the views of the old-timers. But then at the end of the 1950s, the whole idea of growth stocks came back. And they’re still with us today.
Q: Why do you think value or low-risk stocks will produce higher returns and that high-risk or growth stocks will produce lower returns? That flies in the face of current wisdom.
A: Well, if stocks are priced on the basis of future growth potential and growth stocks sell at higher prices relative to current incomes and value stocks sell at lower values relative to current income, and they both have an equal chance of growth, then the value stocks are going to produce high returns in the future, and growth stocks will produce lower returns over time.
I think these forecasts for growth can be improper and cannot really be made, so you’re paying in advance for growth in the growth stocks, and you’re never going to get it. And my book shows this, that value stocks have produced much higher rates of returns over time than growth stocks, and we’re talking about big differences here, at least 13% per year.
Q: But what’s wrong with the way the stock market operates now? Many people are quite happily putting their pension money in growth-stock mutual funds.
A: That’s interesting. Why hasn’t this been obvious to everyone all along if this is so big and really true? The reason is that in the investment business--and this means pension funds and the consulting industry--the time horizons for measuring performance are very short. Everyone wants to know what you did in the last quarter, the last year, maybe the last three. But nobody asks how this investment class has done in the last 20 years, the last 30 years or even the last 10 years.
If you lengthen the time for which you measure performance, then it’s clear that value stocks do better.
Q: So how would you value stocks?
A: In order to correct this mistake, growth stocks need to fall in price by 65%, and value stocks have to rise in price by 35% just to make them even bets, just to make them have the same expected future returns.
Q: Given your theory, what local companies would you consider having higher expected returns, and which will have lower returns?
A: Well, some higher-return companies include Filenet Corp., AST Research Inc., National Education Corp., Standard Pacific and Karcher Enterprises. I consider First American Financial, St. John Knits, Rockwell and Allergan to provide lower returns over time.
Q: What do you hope to accomplish with your new book?
A: I’d like to help inform investors of this mistake that’s been made in the stock market. I’m going to be one of many people who are going to be writing about this in the next few years. And I want to get the word out that this is happening. This has perverse effects on the economy because it creates biases in the costs of capital for these companies. Companies that have been successful in the past have very little cost of capital. But companies that are struggling have very high costs of capital because their stock price is undervalued.
Q: You consult and advise with various pension funds managing investments totaling more than $150 billion. What do you invest in?
A: Personally, I play the January effect, which is that little companies, small ones that don’t pay dividends, tend do well during the first two weeks in January. That’s when informed professional analysts tend to move back into the market and take aggressive positions. And they move back selectively. They buy the stock they think is undervalued. I use mutual funds to play it. I move from basically conservative positions to very aggressive positions. And I sell in the middle of January. Most of the January effect has dissipated by the end of the month.
On his stock-picking computer . . .
“We put in characteristics that describe a company and then the computer eventually estimates the return on the stock. My opinion is that it is amazingly reliable.”
On the stock market . . .
“The market consistently overreacts to the track records of growth by a company and projects those records into the future. “
On retirement . . .
“All you have to do is rank stocks by book-to-price ratio and buy stocks that have the biggest ratio. We can choose between retiring in Diamond Head and Diamond Bar. You buy growth stocks if you want to go to Diamond Bar to retire, and if you want to go to Diamond Head you buy value stocks.”
On pension funds . . .
“They could send their beneficiaries to Diamond Head, but they don’t because they are afraid of losing their jobs. That’s because if you invest in value stocks for a short time . . . there is a chance you will underperform the S&P; 500.”